Barclays Sees Fed Raising Rates Before Reducing Its Balance Sheet

By Michael Aneiro

We’re about an hour away from the Fed’s latest policy statement, and Barclays weighed in late this morning to say that it expects the Fed to begin to re-order its strategy for exiting financial markets. Specifically, Barclays sees the Fed moving toward raising rates before shrinking its balance sheet by selling some of its holdings, a reversal of what the Fed had previously indicated. Here’s Barclays U.S. economist Michael Gapen:

[W]e look for participants to revise their outlook growth and the unemployment rate lower, while boosting the inflation outlook. This implies a faster convergence to the Fed’s targets, with implications for the timing/pace of any rate hike cycle, and should keep the committee focused on the components of the exit strategy.

We believe the committee is moving in the direction of re-ordering the exit strategy in favor of raising rates before shrinking the balance sheet. The Fed first discussed its exit strategy principles in the minutes of the June 2011 FOMC meeting. At the time, the committee felt it needed to drain reserves in advance of any rate hike. The unprecedented level of excess reserves had impaired the functioning of the federal funds market and the monetary policy transmission mechanism. Reserve drainage was a necessary measure to give the FOMC confidence that it could move short-term interest rates higher when needed. Since then, however, excess reserves burgeoned, making any rapid draining ahead of a rate hike difficult, if not impossible, and the Fed has introduced and continues to test the new fixed-rate full-allotment reverse repo facility….

Altogether, we see the developments of the past several years as prompting a re-ordering of the exit strategy. It is not clear whether the committee will garner the necessary consensus for this change at the June meeting, but we expect the topic to come up during the June meetings and think it is likely to be a topic of discussion in the press conference.

Treasury prices continue drifting higher ahead of the Fed, pulling yields lower. The 10-year note is up 6/32 in price, per Tradeweb data, yielding 2.630%, while the 30-year bond is up 12/32 to yield 3.424%. The front end of the yield curve, which is most vulnerable to any changes in Fed rate projections, is still generally unchanged, with the 1-year note down a fraction in price but the 2-year note 1/32 higher.